For years now, central banks have been trying to combat recessions as well as actual or imagined dangers of deflation with zero-interest policies and a flood of liquidity. Naturally, a majority of the European Central Bank’s leadership considers its ultra-loose monetary policy to be the right way to fight the euro zone’s weak growth.
“There are clear signs that the steps that we have initiated in our monetary policy are having an effect,” ECB president Mario Draghi said with pride.
The economy has indeed picked up speed in large sections of the euro zone. But it is open to debate whether the fundamental cause of the upswing is really Mr. Draghi’s monetary policy or rather the low price of oil.
What is undeniable, however, is that this extremely expansive monetary policy has side effects. Due to a surplus of liquidity and lack of significant returns on secure investments, many investors are putting their money in high-yielding stocks or real estate that is supposedly protected against inflation.
This rise in asset prices is often called asset-price inflation. This term is intended to point to a problematic development to which monetary policy should react ― just as it would respond to a rise in the prices of consumer goods. This is, however, not happening.
A strong surge in the price of assets would only be an undesirable development and require a reaction in terms of monetary policy under certain conditions. Price bubbles would have to be driven by speculation and financed by credit and a potential burst would carry the risk of convulsing the financial system and leading to significant losses in the economy.
Despite these undeniable risks of a steep rise in asset prices, the ECB will not react to this development in the stock and real-estate markets. Whether a rise in prices in the end is a pathological bubble only becomes clear after the bubble has burst ― not before.
It is argued further that asset-price inflation leads to a change in the distribution of wealth. The rich get richer through their investments in stocks and real estate, while the poor have to pay the bill in the form of higher rents and, at best, pitifully low rates of interest on savings accounts.
It is a sure bet that the next crash will come. The only question is when.
It is true: When asset prices rise, inequality increases as well ― until the bubble bursts. Then the effect is reversed, and inequality decreases. But the ECB should not concern itself with a just or unjust distribution of wealth. That is not the bank’s mandate, and it carries no responsibility there.
Rising asset prices only constitute a problem for monetary policy when they conceal a price bubble that is financed mostly by credit.
At the end of 1990s, the then-head of America’s Federal Reserve System, Alan Greenspan, spoke of “irrational exuberance” during the dotcom boom. The warning concealed in his words was justified, because the collapse of such price excesses not only brings a write-off of previous book profits but also distorts the economy substantially.
In such a scenario, loans are no longer repaid, banks become unstable and have to be rescued and there is a decline in overall economic production. Unemployment figures also rise and, in the worst case, the entire financial system becomes endangered. A prime example is the collapse of the U.S. housing market in 2007.
We are far from that scenario today, although real-estate prices have risen dramatically in recent years and the German blue chip stock index, DAX, has reached record highs. Nonetheless, no sign exists here of irrational exuberance. This is also the appraisal of the German Central Bank in its report in February.
Even if asset-price inflation continued for a prolonged period, it would not trigger a reaction from the ECB or other large central banks in New York, London and Tokyo. The simple reason: It’s simply not possible to identify with certainty a pathological price bubble before it bursts.
But in contrast to the possible risks of a collapse in real-estate prices or a stock-market crash, the costs of a preventative response to a bubble are always recognizable and, in the case of a soft landing, can be criticized as superfluous and inimical to growth. An independent central bank is loathed to subject itself to what in this case would be an incontrovertible criticism.
So it is a sure bet that the next crash will come. The only question is when.
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